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This has been an occasional theme for us, but after some conversations last week, think it warrants a deeper look. The various parties interacting in the market have become more correlated and the relationships more intricate. The growing use of ETFs by institutions is a key part of that self-reinforcing feedback loop.

A now regular occurrence is a bond trader gets “lifted” in the morning or sells bonds and is left short. That trader waits all day hoping to find a seller of those bonds. At the end of the day, rather than lifting an “egregious” offer, or going home short, they will buy some ETFs to cover the market risk. Of course the next morning, everyone sees the spike in the ETF and views it as a sign that the market got really strong into the close, so they try to buy more bonds. This behavior first became noticeable in the credit markets with the creation of CDS indices but is now occurring with more frequency in the ETF space.

The “arbitrage” community also plays a role in these loops, especially when quoted bond “prices” don’t reflect the reality of where the bonds would trade.

To understand how the feedback loop can create problems, particularly in a down market, it is worth going back to seeing how credit traded in the “old days” like 2007.

Bond Sell-Offs in the “Old Days”

Joey, the trader at a big market maker sends out a run on ShmoGo bonds. It is early in the morning, nothing much going on, futures a bit lower, but nothing that made the trader put much effort into the generic bond run.

A client sees the run, and wants to sell. They call the trader directly, asking him to refresh the ShmoGo 7’s. Joey immediately guesses the client is a seller, so rather than “repeating” the 99.5/100.5 market from the run, quotes the bonds 99/100. The client is a bit annoyed as he clearly hoped to sell at 99.5.

The client that proceeds to explain that everyone and he means “everyone” is 99.25 bid, won’t the trader take a couple at 99.25 to save him from having to call around? By this time, the customer’s salesperson has gotten involved and clearly thinks this is generous of the client, since the trader just flaked on the price and pushes the trader. Now feeling trapped and getting sucked into buying bonds he doesn’t want, the trader protests a little, asking what the client is doing with their overall position.

The trader knows the client has a big block of these bonds and is legitimately concerned that if the client is exiting, then this purchase of a couple million will end very badly. The client insists they are just “trimming” the name. ShmoGo’s are a core part of our strategy, we still love the name, but are just lightening up to cut back from an aggressive overweight to a more normal position. At this stage, trader finally accepts and buys $2 million ShmoGo 7’s at 99.25.

By this time, it’s off to the morning meeting. The trader brings up the “axe” of having to move some ShmoGo 7’s at 100. They spend a half hour going through axes that are unlikely to be filled and listening to a couple research people drone on about some other company that looks cheap and another that is lucky not to be filing tomorrow.

Meanwhile, finally back on the desk, having missed some weak economic data at 8:30 while in their meetings, futures have declined a bit more. There is a slight “risk-off” feeling.

Sales are on the phones with their clients. Senior sales figuring out what their clients want to do and how to get it done, and junior sales trying to flog the morning axes, not completely aware that non of the bids are likely to be there now that the weakness has accelerated.

A little while later a salesperson asks the trader where he is on the ShmoGo 7’s. The trader, a little exasperated by now, shouts out that he can offer them at par, and asks just under his breath, “weren’t you at the morning meeting?” This gets a little chuckle from the entourage of traders around him. Sales is less impressed, but they were expecting this. The respond with, “okay, that’s what I thought, but my guy is telling me that’s pretty generic as its is 99/100 everywhere, and he thinks he could get the bonds at 99.5”. The trader asks the salesperson if their client is a buyer, and after a brief pause while the salesperson checks with the client, he gets the answer that no, they aren’t a buyer, were just giving some color.